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Will higher US rates derail financial markets?

Last week, equity markets witnessed a surge in market volatility with US equity indices posting the largest weekly loss since March this year. Concerns about higher interest rates and trade tensions weighed negatively on sentiment. Many investors wrongly believe that higher interest rates will only impact the bond market. The truth is that rising rates may have negative consequences on various asset classes and with different magnitudes. In recent weeks I wrote about the effects of increasing rates on the bond market and emerging markets. Following the recent spike in the equity volatility, I think it is important to understand what led to this spike in volatility over the last few trading sessions and why spreading your equity exposure across various companies is key, going forward.

Ten years ago, the US Fed was among the first central banks to take action, in order to fight the negative effects of the economic recession which ensued the last financial crisis. Among the drastic measures taken back then was a bold decision to lower interest rates and keep rates at historically low levels for several years. The decision to lower rates was a move intended to boost capital investments and consumer spending with the ultimate goals of generating employment, improve spending power, corporate profits, market sentiment and ultimately economic growth.

Many were those who doubted the effectiveness of these measures on the real economy. As expected, the real effect took its course of time, with unemployment peeking at 10 per cent towards late 2009 and only holding on to its downward path from 2011 onwards. Since then, employment in the world’s largest economy increased significantly and, as at last month, the unemployment rate in the US declined to 3.7 per cent.

While the monetary policy decisions taken back then were necessary for the US Fed to lift the nation from recession, today the central bank is taking interest rates in the opposite direction. In less than three years, the US Fed hiked rates eight times, with the last increase taking place during the last week of September. The impact on the bond market was evident and expected, with the US 10-year Treasury yield hitting nearly 3.25 per cent over the trading sessions which followed.

Spreading your equity exposure across various companies is key going forward

On the contrary, US equities did not react so quickly to the most recent interest hike. The US Fed has taken this path of higher interest rates since economic figures have been improving and showing encouraging signs of a healthy economy. While that is positive for equity investors, as corporate profits are generally higher during positive economic periods, markets tend to fret when rates rise too soon. The reason being that when monetary policy is tightened (higher interest rates), companies invest less as the cost of capital increases, while consumers also spend less, as higher rates encourage them to cut down on spending and save more.

A long period of expansionary monetary policy encourages wealth creation which can eventually lead to market bubbles. With this in mind, and through higher rates, the US Fed aims to reduce the probability of an overheating economy – a situation where lengthy periods of positive economic growth lead to high levels of inflation and over-spending. Among the hardships of too much inflation is a recessionary period. The actions taken by the Fed are surely in the best interest of both the US and the global economy, and the Fed has not gone ‘loco’ because of the recent rates hikes.

Long-term global economic and market stability is key in light of the fact that elsewhere growth is at a different stage of the economic cycle. Growth in Europe and Japan is improving but still sluggish. In addition, emerging markets, which are an important driver of global growth, tend to slow down significantly when recessions loom and risk aversion shoots up.

While the media tends to overblow any abnormal equity market movements, we have to keep in mind that a decade of very low interest rates has generated impressive equity returns across various sub-asset classes within the equity market. While we do not believe equity returns will remain as stellar, we strongly believe that equities should play an important role in one’s portfolio.

Investors have to be mindful of the fact that the asset class contributes towards portfolio volatility. In addition, novice investors should stay away from specific direct equity holdings, to eliminate the possibility of company specific risks which can have significant adverse effects on the value of the portfolio, if anything goes very wrong.

Investors should not be too obsessed with the negative outlook which the financial media tends to depict because the US economy is at a late-cycle stage. With various economies situated at different stages of the economic cycle, we believe that investment opportunities exist. Yet investors are encouraged to veer away from irrational exuberance.

If you are an investor with exposure to equities, you should not become too emotional when markets turn negative and volatility spikes – if you do, you might need to consider your portfolio’s asset allocation and risks. While we are mindful of the price risks of higher interest rates on equities and other asset classes, we strongly believe that Fed’s decision to hike further is beneficial for the long-term stability of economies globally.

This article was prepared by Gabriel Mansueto, branch manager and senior investment advisor at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on 2122 4410 or e-mail gabriel.mansueto@jesmondmizzi.com.

www.jesmondmizzi.com

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